Installment Sales. Contents. For use in preparing 2012 Returns. Publication 537 Cat. No V. Future Developments. Reminder.

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1 Department of the Treasury Internal Revenue Service Publication 537 Cat. No V Installment Sales For use in preparing 2012 Returns Contents Future Developments... 1 Reminder... 1 Introduction... 1 What Is an Installment Sale?... 2 General Rules... 2 Figuring Installment Sale Income... 2 Reporting Installment Sale Income... 4 Other Rules... 4 Electing Out of the Installment Method... 4 Payments Received or Considered Received... 5 Escrow Account... 6 Depreciation Recapture Income... 6 Sale to a Related Person... 7 Like-Kind Exchange... 8 Contingent Payment Sale... 8 Single Sale of Several Assets... 8 Sale of a Business... 9 Unstated Interest and Original Issue Discount (OID) Disposition of an Installment Obligation Repossession Interest on Deferred Tax How To Get Tax Help Index Future Developments For the latest information about developments related to Publication 537, such as legislation enacted after it was published, go to Get forms and other Information faster and easier by: Internet IRS.gov Reminder Photographs of missing children. The Internal Revenue Service (IRS) is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling THE-LOST ( ) if you recognize a child. Introduction Note. Section references within this publication are to the Internal Revenue Code and regulation references are to the Income Tax Regulations under the Code. An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. If you realize a gain on an installment sale, you may be able to report part of your gain when you receive each Dec 04, 2012

2 payment. This method of reporting gain is called the installment method. You cannot use the installment method to report a loss. You can choose to report all of your gain in the year of sale. This publication discusses the general rules that apply to using the installment method. It also discusses more complex rules that apply only when certain conditions exist or certain types of property are sold. If you sell your home or other nonbusiness property under an installment plan, you may need to read only the General Rules. If you sell business or rental property or have a like-kind exchange or other complex situation, also see the appropriate discussion under Other Rules. Comments and suggestions. We welcome your comments about this publication and your suggestions for future editions. You can write to us at the following address: Internal Revenue Service Individual and Specialty Forms and Publications Branch SE:W:CAR:MP:T:I 1111 Constitution Ave. NW, IR-6526 Washington, DC We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence. You can us at taxforms@irs.gov. Please put Publications Comment on the subject line. You can also send us comments from Select Comment on Tax Forms and Publications under More Information. Although we cannot respond individually to each comment received, we do appreciate your feedback and will consider your comments as we revise our tax products. Ordering forms and publications. Visit to download forms and publications, call TAX-FORM ( ), or write to the address below and receive a response within 10 days after your request is received. Internal Revenue Service 1201 N. Mitsubishi Motorway Bloomington, IL Tax questions. If you have a tax question, check the information available on IRS.gov or call We cannot answer tax questions sent to either of the above addresses. Useful Items You may want to see: Publication Selling Your Home Accounting Periods and Methods Partnerships Sales and Other Dispositions of Assets Investment Income and Expenses Basis of Assets 925 Passive Activity and At-Risk Rules 4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments 4895 Tax Treatment of Property Acquired From a Decedent Dying in 2010 Form (and Instructions) 4797 Sales of Business Property 6252 Installment Sale Income See How To Get Tax Help near the end of this publication for information about getting publications and forms. What Is an Installment Sale? An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. The rules for installment sales do not apply if you elect not to use the installment method (see Electing Out of the Installment Method under Other Rules, later) or the transaction is one for which the installment method may not apply. The installment sales method cannot be used for the following. Sale of inventory. The regular sale of inventory of personal property does not qualify as an installment sale even if you receive a payment after the year of sale. See Sale of a Business under Other Rules, later. Dealer sales. Sales of personal property by a person who regularly sells or otherwise disposes of the same type of personal property on the installment plan are not installment sales. This rule also applies to real property held for sale to customers in the ordinary course of a trade or business. However, the rule does not apply to an installment sale of property used or produced in farming. Special rule. Dealers of time-shares and residential lots can treat certain sales as installment sales and report them under the installment method if they elect to pay a special interest charge. For more information, see section 453(l). Stock or securities. You cannot use the installment method to report gain from the sale of stock or securities traded on an established securities market. You must report the entire gain on the sale in the year in which the trade date falls. Installment obligation. The buyer's obligation to make future payments to you can be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer's debt to you. General Rules If a sale qualifies as an installment sale, the gain must be reported under the installment method unless you elect out of using the installment method. See Electing Out of the Installment Method under Other Rules, later, for information on recognizing the entire gain in the year of sale. Sale at a loss. If your sale results in a loss, you cannot use the installment method. If the loss is on an installment sale of business or investment property, you can deduct it only in the tax year of sale. Unstated interest. If your sale calls for payments in a later year and the sales contract provides for little or no interest, you may have to figure unstated interest, even if you have a loss. See Unstated Interest and Original Issue Discount (OID) under Other Rules, later. Figuring Installment Sale Income You can use the following discussions or Form 6252 to help you determine gross profit, contract price, gross profit percentage, and installment sale income. Each payment on an installment sale usually consists of the following three parts. Interest income. Return of your adjusted basis in the property. Gain on the sale. In each year you receive a payment, you must include in income both the interest part and the part that is your gain on the sale. You do not include in income the part that is the return of your basis in the property. Basis is the amount of your investment in the property for installment sale purposes. Interest Income You must report interest as ordinary income. Interest is generally not included in a down payment. However, you may have to treat part of each later payment as interest, even if it is not called interest in your agreement with the buyer. Interest provided in the agreement is called stated interest. If the agreement does not provide for enough stated interest, there may be unstated interest or original issue discount. See Unstated Interest and Original Issue Discount (OID) under Other Rules, later. Adjusted Basis and Installment Sale Income (Gain on Sale) After you have determined how much of each payment to treat as interest, you treat the rest of each payment as if it were made up of two parts. A tax-free return of your adjusted basis in the property, and Your gain (referred to as installment sale income on Form 6252). Figuring adjusted basis for installment sale purposes. You can use Worksheet A to figure your adjusted basis in the property for installment sale purposes. When you have completed the worksheet, you will also have determined the gross profit percentage necessary to figure your installment sale income (gain) for this year. Page 2 Publication 537 (2012)

3 Worksheet A. Figuring Adjusted Basis and Gross Profit Percentage 1. Enter the selling price for the property Enter your adjusted basis for the property Enter your selling expenses Enter any depreciation recapture Add lines 2, 3, and 4. This is your adjusted basis for installment sale purposes Subtract line 5 from line 1. If zero or less, enter -0-. This is your gross profit... If the amount entered on line 6 is zero, stop here. You cannot use the installment method. 7. Enter the contract price for the property Divide line 6 by line 7. This is your gross profit percentage... Selling price. The selling price is the total cost of the property to the buyer and includes any of the following. Any money you are to receive. The fair market value (FMV) of any property you are to receive (FMV is discussed in Property Used As a Payment under Other Rules, later). Any existing mortgage or other debt the buyer pays, assumes, or takes (a note, mortgage, or any other liability, such as a lien, accrued interest, or taxes you owe on the property). Any of your selling expenses the buyer pays. Do not include stated interest, unstated interest, any amount recomputed or recharacterized as interest, or original issue discount. Adjusted basis for installment sale purposes. Your adjusted basis is the total of the following three items. Adjusted basis. Selling expenses. Depreciation recapture. Adjusted basis. Basis is your investment in the property for installment sale purposes. The way you figure basis depends on how you acquire the property. The basis of property you buy is generally its cost. The basis of property you inherit, receive as a gift, build yourself, or receive in a tax-free exchange is figured differently. While you own property, various events may change your original basis. Some events, such as adding rooms or making permanent improvements, increase basis. Others, such as deductible casualty losses or depreciation previously allowed or allowable, decrease basis. The result is adjusted basis. For more information on how to figure basis and adjusted basis, see Publication 551. For more information regarding your basis in property you inherited from someone who died in 2010 and whose executor filed Form 8939, see Publication Keep for Your Records expenses paid on the sale. Selling expenses are added to the basis of the sold property. Depreciation recapture. If the property you sold was depreciable property, you may need to recapture part of the gain on the sale as ordinary income. See Depreciation Recapture Income under Other Rules, later. Gross profit. Gross profit is the total gain you report on the installment method. To figure your gross profit, subtract your adjusted basis for installment sale purposes from the selling price. If the property you sold was your home, subtract from the gross profit any gain you can exclude. See Sale of Your Home, later, under Reporting Installment Sale Income. Contract price. Contract price equals: 1. The selling price, minus 2. The mortgages, debts, and other liabilities assumed or taken by the buyer, plus 3. The amount by which the mortgages, debts, and other liabilities assumed or taken by the buyer exceed your adjusted basis for installment sale purposes. Gross profit percentage. A certain percentage of each payment (after subtracting interest) is reported as installment sale income. This percentage is called the gross profit percentage and is figured by dividing your gross profit from the sale by the contract price. The gross profit percentage generally remains the same for each payment you receive. However, see the Example under Selling Price Reduced, later, for a situation where the gross profit percentage changes. Example. You sell property at a contract price of $6,000 and your gross profit is $1,500. Your gross profit percentage is 25% ($1,500 $6,000). After subtracting interest, you report 25% of each payment, including the down payment, as installment sale income from the sale for the tax year you receive the payment. The remainder (balance) of each payment is the tax-free return of your adjusted basis. year (less interest) by the gross profit percentage. The result is your installment sale income for the tax year. In certain circumstances, you may be treated as having received a payment, even though you received nothing directly. A receipt of property or the assumption of a mortgage on the property sold may be treated as a payment. For a detailed discussion, see Payments Received or Considered Received under Other Rules, later. Selling Price Reduced If the selling price is reduced at a later date, the gross profit on the sale also will change. You then must refigure the gross profit percentage for the remaining payments. Refigure your gross profit using Worksheet B. You will spread any remaining gain over future installments. Example. In 2010, you sold land with a basis of $40,000 for $100,000. Your gross profit was $60,000. You received a $20,000 down payment and the buyer's note for $80,000. The note provides for four annual payments of $20,000 each, plus 8% interest, beginning in Your gross profit percentage is 60%. You reported a gain of $12,000 on each payment received in 2010 and In 2012, you and the buyer agreed to reduce the purchase price to $85,000 and payments during 2012, 2013, and 2014 are reduced to $15,000 for each year. The new gross profit percentage, 46.67%, is figured on Worksheet B. You will report a gain of $7,000 (46.67% of $15,000) on each of the $15,000 installments due in 2012, 2013, and Example New Gross Profit Worksheet B. Percentage Selling Price Reduced 1. Enter the reduced selling price for the property... 85, Enter your adjusted basis for the property... 40, Enter your selling expenses Enter any depreciation recapture Add lines 2, 3, and , Subtract line 5 from line 1. This is your adjusted gross profit... 45, Enter any installment sale income reported in prior year(s)... 24, Subtract line 7 from line , Future installments... 45, Divide line 8 by line 9. This is your new gross profit percentage * % * Apply this percentage to all future payments to determine how much of each of those payments is installment sale income. Selling expenses. Selling expenses relate to the sale of the property. They include commissions, attorney fees, and any other Amount to report as installment sale income. Multiply the payments you receive each Publication 537 (2012) Page 3

4 Reporting Installment Sale Income Generally, you will use Form 6252 to report installment sale income from casual sales of real or personal property during the tax year. You also will have to report the installment sale income on Schedule D (Form 1040), Capital Gains and Losses, or Form 4797, or both. See Schedule D (Form 1040) and Form 4797, later. If the property was your main home, you may be able to exclude part or all of the gain. See Sale of Your Home, later. Form 6252 Use Form 6252 to report an installment sale in the year it takes place and to report payments received, or considered received because of related party resales, in later years. Attach it to your tax return for each year. Form 6252 will help you determine the gross profit, contract price, gross profit percentage, and installment sale income. Which parts to complete. Which part to complete depends on whether you are filing the form for the year of sale or a later year. Year of sale. Complete lines 1 through 4, Part I, and Part II. If you sold property to a related party during the year, also complete Part III. Later years. Complete lines 1 through 4 and Part II for any year in which you receive a payment from an installment sale. If you sold a marketable security to a related party after May 14, 1980, and before January 1, 1987, complete Form 6252 for each year of the installment agreement, even if you did not receive a payment. (After December 31, 1986, the installment method is not available for the sale of marketable securities.) Complete lines 1 through 4 and Part II for any year in which you receive a payment from the sale. Complete Part III unless you received the final payment during the tax year. If you sold property other than a marketable security to a related party after May 14, 1980, complete Form 6252 for the year of sale and for 2 years after the year of sale, even if you did not receive a payment. Complete lines 1 through 4 and Part II for any year during this 2-year period in which you receive a payment from the sale. Complete Part III for the 2 years after the year of sale unless you received the final payment during the tax year. Schedule D (Form 1040) Enter the gain figured on Form 6252 (line 26) for personal-use property (capital assets) on Schedule D (Form 1040), as a short-term gain (line 4) or long-term gain (line 11). If your gain from the installment sale qualifies for long-term capital gain treatment in the year of sale, it will continue to qualify in later tax years. Your gain is long-term if you owned the property for more than 1 year when you sold it. Form 4797 An installment sale of property used in your business or that earns rent or royalty income may result in a capital gain, an ordinary gain, or both. All or part of any gain from the disposition Worksheet B. New Gross Profit Percentage Selling Price Reduced 1. Enter the reduced selling price for the property Enter your adjusted basis for the property Enter your selling expenses Enter any depreciation recapture Add lines 2, 3, and Subtract line 5 from line 1. This is your adjusted gross profit Enter any installment sale income reported in prior year(s) Subtract line 7 from line Future installments Divide line 8 by line 9. This is your new gross profit percentage *.... of the property may be ordinary gain from depreciation recapture. For trade or business property held for more than 1 year, enter the amount from line 26 of Form 6252 on Form 4797, line 4. If the property was held 1 year or less or you have an ordinary gain from the sale of a noncapital asset (even if the holding period is more than 1 year), enter this amount on Form 4797, line 10, and write From Form Sale of Your Home If you sell your home, you may be able to exclude all or part of the gain on the sale. See Publication 523 for information about excluding the gain. If the sale is an installment sale, any gain you exclude is not included in gross profit when figuring your gross profit percentage. Seller financed mortgage. If you finance the sale of your home to an individual, both you and the buyer may have to follow special reporting procedures. When you report interest income received from a buyer who uses the property as a personal residence, write the buyer's name, address, and social security number (SSN) on line 1 of Schedule B (Form 1040A or 1040), Interest and Ordinary Dividends. When deducting the mortgage interest, the buyer must write your name, address, and SSN on line 11 of Schedule A (Form 1040), Itemized Deductions. If either person fails to include the other person's SSN, a $50 penalty will be assessed. Other Rules Keep for Your Records * Apply this percentage to all future payments to determine how much of each of those payments is installment sale income. The rules discussed in this part of the publication apply only in certain circumstances or to certain types of property. The following topics are discussed. Electing out of the installment method. Payments received or considered received. Escrow account. Depreciation recapture income. Sale to a related person. Like-kind exchange. Contingent payment sale. Single sale of several assets. Sale of a business. Unstated interest and original issue discount. Disposition of an installment obligation. Repossession. Interest on deferred tax. Electing Out of the Installment Method If you elect not to use the installment method, you generally report the entire gain in the year of sale, even though you do not receive all the sale proceeds in that year. To figure the amount of gain to report, use the fair market value (FMV) of the buyer's installment obligation that represents the buyer's Page 4 Publication 537 (2012)

5 debt to you. Notes, mortgages, and land contracts are examples of obligations that are included at FMV. You must figure the FMV of the buyer's installment obligation, whether or not you would actually be able to sell it. If you use the cash method of accounting, the FMV of the obligation will never be considered to be less than the FMV of the property sold (minus any other consideration received). Example. You sold a parcel of land for $50,000. You received a $10,000 down payment and will receive the balance over the next 10 years at $4,000 a year, plus 8% interest. The buyer gave you a note for $40,000. The note had an FMV of $40,000. You paid a commission of 6%, or $3,000, to a broker for negotiating the sale. The land cost $25,000, and you owned it for more than one year. You decide to elect out of the installment method and report the entire gain in the year of sale. Gain realized: Selling price $50,000 Minus: Property's adj. basis $25,000 Commission ,000 28,000 Gain realized $22,000 Gain recognized in year of sale: Cash $10,000 Market value of note ,000 Total realized in year of sale $50,000 Minus: Property's adj. basis $25,000 Commission ,000 28,000 Gain recognized $22,000 The recognized gain of $22,000 is long-term capital gain. You include the entire gain in income in the year of sale, so you do not include in income any principal payments you receive in later tax years. The interest on the note is ordinary income and is reported as interest income each year. How to elect out. To make this election, do not report your sale on Form Instead, report it on Form 8949, Form 4797, or both. When to elect out. Make this election by the due date, including extensions, for filing your tax return for the year the sale takes place. Automatic six month extension. If you timely file your tax return without making the election, you still can make the election by filing an amended return within 6 months of the due date of your return (excluding extensions). Write Filed pursuant to section at the top of the amended return and file it where the original return was filed. Revoking the election. Once made, the election can be revoked only with IRS approval. A revocation is retroactive. You will not be allowed to revoke the election if either of the following applies. One of the purposes is to avoid federal income tax. The tax year in which any payment was received has closed. Payments Received or Considered Received You must figure your gain each year on the payments you receive, or are treated as receiving, from an installment sale. In certain situations, you are considered to have received a payment, even though the buyer does not pay you directly. These situations occur when the buyer assumes or pays any of your debts, such as a loan, or pays any of your expenses, such as a sales commission. However, as discussed later, the buyer's assumption of your debt is treated as a recovery of your basis rather than as a payment in many cases. Buyer Pays Seller's Expenses If the buyer pays any of your expenses related to the sale of your property, it is considered a payment to you in the year of sale. Include these expenses in the selling and contract prices when figuring the gross profit percentage. Buyer Assumes Mortgage If the buyer assumes or pays off your mortgage, or otherwise takes the property subject to the mortgage, the following rules apply. Mortgage less than basis. If the buyer assumes a mortgage that is not more than your installment sale basis in the property, it is not considered a payment to you. It is considered a recovery of your basis. The contract price is the selling price minus the mortgage. Example. You sell property with an adjusted basis of $19,000. You have selling expenses of $1,000. The buyer assumes your existing mortgage of $15,000 and agrees to pay you $10,000 (a cash down payment of $2,000 and $2,000 (plus 12% interest) in each of the next 4 years). The selling price is $25,000 ($15,000 + $10,000). Your gross profit is $5,000 ($25,000 $20,000 installment sale basis). The contract price is $10,000 ($25,000 $15,000 mortgage). Your gross profit percentage is 50% ($5,000 $10,000). You report half of each $2,000 payment received as gain from the sale. You also report all interest you receive as ordinary income. Mortgage more than basis. If the buyer assumes a mortgage that is more than your installment sale basis in the property, you recover your entire basis. The part of the mortgage greater than your basis is treated as a payment received in the year of sale. To figure the contract price, subtract the mortgage from the selling price. This is the total amount (other than interest) you will receive directly from the buyer. Add to this amount the payment you are considered to have received (the difference between the mortgage and your installment sale basis). The contract price is then the same as your gross profit from the sale. If the mortgage the buyer assumes is TIP equal to or more than your installment sale basis, the gross profit percentage always will be 100%. Example. The selling price for your property is $9,000. The buyer will pay you $1,000 annually (plus 8% interest) over the next 3 years and assume an existing mortgage of $6,000. Your adjusted basis in the property is $4,400. You have selling expenses of $600, for a total installment sale basis of $5,000. The part of the mortgage that is more than your installment sale basis is $1,000 ($6,000 $5,000). This amount is included in the contract price and treated as a payment received in the year of sale. The contract price is $4,000: Selling price $9,000 Minus: Mortgage (6,000) Amount actually received $3,000 Add difference: Mortgage $6,000 Minus: Installment sale basis ,000 1,000 Contract price $4,000 Your gross profit on the sale is also $4,000: Selling price $9,000 Minus: Installment sale basis (5,000) Gross profit $4,000 Your gross profit percentage is 100%. Report 100% of each payment (less interest) as gain from the sale. Treat the $1,000 difference between the mortgage and your installment sale basis as a payment and report 100% of it as gain in the year of sale. Mortgage Canceled If the buyer of your property is the person who holds the mortgage on it, your debt is canceled, not assumed. You are considered to receive a payment equal to the outstanding canceled debt. Example. Mary Jones loaned you $45,000 in 2008 in exchange for a note mortgaging a tract of land you owned. On April 4, 2012, she bought the land for $70,000. At that time, $30,000 of her loan to you was outstanding. She agreed to forgive this $30,000 debt and to pay you $20,000 (plus interest) on August 1, 2012, and $20,000 on August 1, She did not assume an existing mortgage. She canceled the $30,000 debt you owed her. You are considered to have received a $30,000 payment at the time of the sale. Buyer Assumes Other Debts If the buyer assumes any other debts, such as a loan or back taxes, it may be considered a payment to you in the year of sale. If the buyer assumes the debt instead of paying it off, only part of it may have to be treated as a payment. Compare the debt to your installment sale basis in the property being sold. If the debt is less than your installment sale basis, none of it is treated as a payment. If it is more, only the difference is treated as a payment. If the buyer assumes more than one debt, any part of the total that is more than your installment sale basis is considered a payment. These rules are the same as the rules discussed earlier under Buyer Assumes Mortgage. Publication 537 (2012) Page 5

6 However, they apply only to the following types of debt the buyer assumes. Those acquired from ownership of the property you are selling, such as a mortgage, lien, overdue interest, or back taxes. Those acquired in the ordinary course of your business, such as a balance due for inventory you purchased. If the buyer assumes any other type of debt, such as a personal loan or your legal fees relating to the sale, it is treated as if the buyer had paid off the debt at the time of the sale. The value of the assumed debt is then considered a payment to you in the year of sale. Property Used As a Payment If you receive property rather than money from the buyer, it is still considered a payment in the year received. However, see Like Kind Exchange, later. Generally, the amount of the payment is the property's FMV on the date you receive it. Exception. If the property the buyer gives you is payable on demand or readily tradable, the amount you should consider as payment in the year received is: The FMV of the property on the date you receive it if you use the cash method of accounting, The face amount of the obligation on the date you receive it if you use the accrual method of accounting, or The stated redemption price at maturity less any original issue discount (OID) or, if there is no OID, the stated redemption price at maturity appropriately discounted to reflect total unstated interest. See Unstated Interest and Original Issue Discount (OID), later. Debt not payable on demand. Any evidence of debt you receive from the buyer not payable on demand is not considered a payment. This is true even if the debt is guaranteed by a third party, including a government agency. Fair market value (FMV). This is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of all the necessary facts. Third party note. If the property the buyer gives you is a third-party note (or other obligation of a third party), you are considered to have received a payment equal to the note's FMV. Because the FMV of the note is itself a payment on your installment sale, any payments you later receive from the third party are not considered payments on the sale. The excess of the note's face value over its FMV is interest. Exclude this interest in determining the selling price of the property. However, see Exception under Property Used As a Payment, earlier. Example. You sold real estate in an installment sale. As part of the down payment, the buyer assigned to you a $50,000, 8% interest third-party note. The FMV of the third-party note at the time of the sale was $30,000. This amount, not $50,000, is a payment to you in the year of sale. The third-party note had an FMV equal to 60% of its face value ($30,000 $50,000), so 60% of each principal payment you receive on this note is a nontaxable return of capital. The remaining 40% is interest taxed as ordinary income. Bond. A bond or other evidence of debt you receive from the buyer that is payable on demand or readily tradable in an established securities market is treated as a payment in the year you receive it. For more information on the amount you should treat as a payment, see Exception under Property Used As a Payment, earlier. If you receive a government or corporate bond for a sale before October 22, 2004, and the bond has interest coupons attached or can be readily traded in an established securities market, you are considered to have received payment equal to the bond's FMV. However, see Exception under Property Used As a Payment, earlier. Buyer's note. The buyer's note (unless payable on demand) is not considered payment on the sale. However, its full face value is included when figuring the selling price and the contract price. Payments you receive on the note are used to figure your gain in the year received. Installment Obligation Used as Security (Pledge Rule) If you use an installment obligation to secure any debt, the net proceeds from the debt may be treated as a payment on the installment obligation. This is known as the pledge rule, and it applies if the selling price of the property is over $150,000. It does not apply to the following dispositions. Sales of property used or produced in farming. Sales of personal-use property. Qualifying sales of time-shares and residential lots. The net debt proceeds are the gross debt minus the direct expenses of getting the debt. The amount treated as a payment is considered received on the later of the following dates. The date the debt becomes secured. The date you receive the debt proceeds. A debt is secured by an installment obligation to the extent that payment of principal or interest on the debt is directly secured (under the terms of the loan or any underlying arrangement) by any interest in the installment obligation. For sales after December 16, 1999, payment on a debt is treated as directly secured by an interest in an installment obligation to the extent an arrangement allows you to satisfy all or part of the debt with the installment obligation. Limit. The net debt proceeds treated as a payment on the pledged installment obligation cannot be more than the excess of item (1) over item (2), below. 1. The total contract price on the installment sale. 2. Any payments received on the installment obligation before the date the net debt proceeds are treated as a payment. Installment payments. The pledge rule accelerates the reporting of the installment obligation payments. Do not report payments received on the obligation after it has been pledged until the payments received exceed the amount reported under the pledge rule. Exception. The pledge rule does not apply to pledges made after December 17, 1987, to refinance a debt under the following circumstances. The debt was outstanding on December 17, The debt was secured by that installment sale obligation on that date and at all times thereafter until the refinancing occurred. A refinancing as a result of the creditor's calling of the debt is treated as a continuation of the original debt so long as a person other than the creditor or a person related to the creditor provides the refinancing. This exception applies only to refinancing that does not exceed the principal of the original debt immediately before the refinancing. Any excess is treated as a payment on the installment obligation. Escrow Account In some cases, the sales agreement or a later agreement may call for the buyer to establish an irrevocable escrow account from which the remaining installment payments (including interest) are to be made. These sales cannot be reported on the installment method. The buyer's obligation is paid in full when the balance of the purchase price is deposited into the escrow account. When an escrow account is established, you no longer rely on the buyer for the rest of the payments, but on the escrow arrangement. Example. You sell property for $100,000. The sales agreement calls for a down payment of $10,000 and payment of $15,000 in each of the next 6 years to be made from an irrevocable escrow account containing the balance of the purchase price plus interest. You cannot report the sale on the installment method because the full purchase price is considered received in the year of sale. You report the entire gain in the year of sale. Escrow established in a later year. If you make an installment sale and in a later year an irrevocable escrow account is established to pay the remaining installments plus interest, the amount placed in the escrow account represents payment of the balance of the installment obligation. Substantial restriction. If an escrow arrangement imposes a substantial restriction on your right to receive the sale proceeds, the sale can be reported on the installment method, provided it otherwise qualifies. For an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the buyer, that is, a real and definite restriction placed on the seller or a specific economic benefit conferred on the buyer. Depreciation Recapture Income If you sell property for which you claimed or could have claimed a depreciation deduction, Page 6 Publication 537 (2012)

7 you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form Report the recapture income in Part II of Form 4797 as ordinary income in the year of sale. The recapture income is also included in Part I of Form However, the gain equal to the recapture income is reported in full in the year of the sale. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 in Publication 544. The recapture income reported in the year of sale is included in your installment sale basis in determining your gross profit on the installment sale. Determining gross profit is discussed under General Rules, earlier. Sale to a Related Person If you sell depreciable property to a related person and the sale is an installment sale, you may not be able to report the sale using the installment method. If you sell property to a related person and the related person disposes of the property before you receive all payments with respect to the sale, you may have to treat the amount realized by the related person as received by you when the related person disposes of the property. These rules are explained under Sale of Depreciable Property and under Sale and Later Disposition, later. Sale of Depreciable Property If you sell depreciable property to certain related persons, you generally cannot report the sale using the installment method. Instead, all payments to be received are considered received in the year of sale. However, see Exception, below. Depreciable property for this rule is any property the purchaser can depreciate. Payments to be received include the total of all noncontingent payments and the FMV of any payments contingent as to amount. In the case of contingent payments for which the FMV cannot be reasonably determined, your basis in the property is recovered proportionately. The purchaser cannot increase the basis of the property acquired in the sale before the seller includes a like amount in income. Exception. You can use the installment method to report a sale of depreciable property to a related person if no significant tax deferral benefit will be derived from the sale. You must show to the satisfaction of the IRS that avoidance of federal income tax was not one of the principal purposes of the sale. Related person. Related persons include the following. A person and all controlled entities with respect to that person. A taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary, unless that beneficiary's interest in the trust is a remote contingent interest. Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of that estate. Two or more partnerships in which the same person owns, directly or indirectly, more than 50% of the capital interests or the profits interests. For information about which entities are controlled entities, see section 1239(c). Sale and Later Disposition Generally, a special rule applies if you sell or exchange property to a related person on the installment method (first disposition) who then sells, exchanges, or gives away the property (second disposition) under the following circumstances. The related person makes the second disposition before making all payments on the first disposition. The related person disposes of the property within 2 years of the first disposition. This rule does not apply if the property involved is marketable securities. Under this rule, you treat part or all of the amount the related person realizes (or the FMV if the disposed property is not sold or exchanged) from the second disposition as if you received it at the time of the second disposition. See Exception, later. Related person. Related persons include the following. Members of a family, including only brothers and sisters (either whole or half), husband and wife, ancestors, and lineal descendants. A partnership or estate and a partner or beneficiary. A trust (other than a section 401(a) employees trust) and a beneficiary. A trust and an owner of the trust. Two corporations that are members of the same controlled group as defined in section 267(f). The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts. A tax-exempt educational or charitable organization and a person (if an individual, including members of the individual's family) who directly or indirectly controls such an organization. An individual and a corporation when the individual owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation. A fiduciary of a trust and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation. The grantor and fiduciary, and the fiduciary and beneficiary, of any trust. Any two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation. An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation. A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership. An executor and a beneficiary of an estate unless the sale is in satisfaction of a pecuniary bequest. Example 1. In 2011, Harvey Green sold farm land to his son Bob for $500,000, which was to be paid in five equal payments over 5 years, plus adequate stated interest on the balance due. His installment sale basis for the farm land was $250,000 and the property was not subject to any outstanding liens or mortgages. His gross profit percentage is 50% (gross profit of $250,000 contract price of $500,000). He received $100,000 in 2011 and included $50,000 in income for that year ($100, ). Bob made no improvements to the property and sold it to Alfalfa Inc., in 2012 for $600,000 after making the payment for that year. The amount realized from the second disposition is $600,000. Harvey figures his installment sale income for 2012 as follows: Lesser of: 1) Amount realized on second disposition, or 2) Contract price on first disposition $500,000 Subtract: Sum of payments from Bob in 2011 and ,000 Amount treated as received because of second disposition $300,000 Add: Payment from Bob in ,000 Total payments received and treated as received for $400,000 Multiply by gross profit % Installment sale income for $200,000 Harvey will not include in his installment sale income any principal payments he receives on the installment obligation for 2013, 2014, and 2015 because he has already reported the total payments of $500,000 from the first disposition ($100,000 in 2011 and $400,000 in 2012). Example 2. Assume the facts are the same as Example 1 except that Bob sells the property for only $400,000. The gain for 2012 is figured as follows: Lesser of: 1) Amount realized on second disposition, or 2) Contract price on first disposition $400,000 Subtract: Sum of payments from Bob in 2011 and ,000 Amount treated as received because of second disposition $200,000 Add: Payment from Bob in ,000 Total payments received and treated as received for $300,000 Multiply by gross profit % Installment sale income for $150,000 Harvey receives a $100,000 payment in 2013 and another in They are not taxed because he treated the $200,000 from the disposition in 2012 as a payment received and paid tax on the installment sale income. In 2015, he receives the final $100,000 payment. He figures the installment sale income he must recognize in 2015 as follows: Publication 537 (2012) Page 7

8 Total payments from the first disposition received by the end of $500,000 Minus the sum of: Payment from $100,000 Payment from ,000 Amount treated as received in ,000 Total on which gain was previously 400,000 recognized Payment on which gain is recognized for $100, Multiply by gross profit % Installment sale income for $ 50,000 Exception. This rule does not apply to a second disposition, and any later transfer, if you can show to the satisfaction of the IRS that neither the first disposition (to the related person) nor the second disposition had as one of its principal purposes the avoidance of federal income tax. Generally, an involuntary second disposition will qualify under the nontax avoidance exception, such as when a creditor of the related person forecloses on the property or the related person declares bankruptcy. The nontax avoidance exception also applies to a second disposition that is also an installment sale if the terms of payment under the installment resale are substantially equal to or longer than those for the first installment sale. However, the exception does not apply if the resale terms permit significant deferral of recognition of gain from the first sale. In addition, any sale or exchange of stock to the issuing corporation is not treated as a first disposition. An involuntary conversion is not treated as a second disposition if the first disposition occurred before the threat of conversion. A transfer after the death of the person making the first disposition or the related person's death, whichever is earlier, is not treated as a second disposition. Like Kind Exchange If you trade business or investment property solely for the same kind of property to be held as business or investment property, you can postpone reporting the gain. These trades are known as like-kind exchanges. The property you receive in a like-kind exchange is treated as if it were a continuation of the property you gave up. You do not have to report any part of your gain if you receive only like-kind property. However, if you also receive money or other property (boot) in the exchange, you must report your gain to the extent of the money and the FMV of the other property received. For more information on like-kind exchanges, see Like Kind Exchanges in chapter 1 of Publication 544. Installment payments. If, in addition to like-kind property, you receive an installment obligation in the exchange, the following rules apply to determine the installment sale income each year. The contract price is reduced by the FMV of the like-kind property received in the trade. The gross profit is reduced by any gain on the trade that can be postponed. Like-kind property received in the trade is not considered payment on the installment obligation. Example. In 2012, George Brown trades personal property with an installment sale basis of $400,000 for like-kind property having an FMV of $200,000. He also receives an installment note for $800,000 in the trade. Under the terms of the note, he is to receive $100,000 (plus interest) in 2013 and the balance of $700,000 (plus interest) in George's selling price is $1,000,000 ($800,000 installment note + $200,000 FMV of like-kind property received). His gross profit is $600,000 ($1,000,000 $400,000 installment sale basis). The contract price is $800,000 ($1,000,000 $200,000). The gross profit percentage is 75% ($600,000 $800,000). He reports no gain in 2012 because the like-kind property he receives is not treated as a payment for figuring gain. He reports $75,000 gain for 2013 (75% of $100,000 payment received) and $525,000 gain for 2014 (75% of $700,000 payment received). Deferred exchanges. A deferred exchange is one in which you transfer property you use in business or hold for investment and receive like-kind property later that you will use in business or hold for investment. Under this type of exchange, the person receiving your property may be required to place funds in an escrow account or trust. If certain rules are met, these funds will not be considered a payment until you have the right to receive the funds or, if earlier, the end of the exchange period. See Regulations section (k)-1(j)(2) for these rules. Contingent Payment Sale A contingent payment sale is one in which the total selling price cannot be determined by the end of the tax year of sale. This happens, for example, if you sell your business and the selling price includes a percentage of its profits in future years. If the selling price cannot be determined by the end of the tax year, you must use different rules to figure the contract price and the gross profit percentage than those you use for an installment sale with a fixed selling price. For rules on using the installment method for a contingent payment sale, see Regulations section 15a.453-1(c). Single Sale of Several Assets If you sell different types of assets in a single sale, you must identify each asset to determine whether you can use the installment method to report the sale of that asset. You also have to allocate part of the selling price to each asset. If you sell assets that constitute a trade or business, see Sale of a Business, later. Unless an allocation of the selling price has been agreed to by both parties in an arm's-length transaction, you must allocate the selling price to an asset based on its FMV. If the buyer assumes a debt, or takes the property subject to a debt, you must reduce the FMV of the property by the debt. This becomes the net FMV. A sale of separate and unrelated assets of the same type under a single contract is reported as one transaction for the installment method. However, if an asset is sold at a loss, its disposition cannot be reported on the installment method. It must be reported separately. The remaining assets sold at a gain are reported together. Example. You sold three separate and unrelated parcels of real property (A, B, and C) under a single contract calling for a total selling price of $130,000. The total selling price consisted of a cash payment of $20,000, the buyer's assumption of a $30,000 mortgage on parcel B, and an installment obligation of $80,000 payable in eight annual installments, plus interest at 8% a year. Your installment sale basis for each parcel was $15,000. Your net gain was $85,000 ($130,000 $45,000). You report the gain on the installment method. The sales contract did not allocate the selling price or the cash payment received in the year of sale among the individual parcels. The FMV of parcels A, B, and C were $60,000, $60,000, and $10,000, respectively. The installment sale basis for parcel C was more than its FMV, so it was sold at a loss and must be treated separately. You must allocate the total selling price and the amounts received in the year of sale between parcel C and the remaining parcels. Of the total $130,000 selling price, you must allocate $120,000 to parcels A and B together and $10,000 to parcel C. You should allocate the cash payment of $20,000 received in the year of sale and the note receivable on the basis of their proportionate net FMV. The allocation is figured as follows: Parcels A and B Parcel C FMV $120,000 $10,000 Minus: Mortgage assumed , Net FMV $ 90,000 $10,000 Proportionate net FMV: Percentage of total % 10% Payments in year of sale: $20,000 90% $18,000 $20,000 10% $2,000 Excess of parcel B mortgage over installment sale basis , Allocation of payments received (or considered received) in year of sale.... $ 33,000 $ 2,000 You cannot report the sale of parcel C on the installment method because the sale results in a loss. You report this loss of $5,000 ($10,000 selling price $15,000 installment sale basis) in the year of sale. However, if parcel C was held for personal use, the loss is not deductible. You allocate the installment obligation of $80,000 to the properties sold based on their proportionate net FMVs (90% to parcels A and B, 10% to parcel C). Page 8 Publication 537 (2012)

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